In hindsight, GameStop’s (GME) unthinkable January price runup was always going to end in a government response, and that’s precisely what occurred on Thursday. For over five hours, the U.S. House Financial Services Committee grilled various characters in the GameStop soap opera, including the CEOs of Robinhood, Melvin Capital, Reddit, and Citadel, as well as Reddit hero Keith Gill, aka Roaring Kitty.
For investors looking to glean insights on the direction of federal securities regulations under Biden, the state of stock markets, and the power dynamics on Wall Street, the hearing included several interesting takeaways. Here are three of them.
1. Retail Enthusiasm for Options is Higher Than Ever
Mass buying of call options was central to the mechanics of GameStop’s skyrocketing price. As more retail traders like Keith Gill purchased call options, market makers on the other side of the trade were forced to acquire shares to hedge their bets, thus forcing up the stock price.
Robinhood CEO Vlad Tenev revealed in his testimony that 13% of Robinhood's customers have purchased options contracts, and that some two-thirds of Robinhood's revenue in the fourth quarter of 2020 came from options trading. Together, these data show that a comparatively small group of options traders are especially active investors who are shaping market activity across asset classes, from large cap stocks like Tesla (TSLA), to commodities like Silver, to shorted stocks like GameStop and AMC (AMC).
What’s more, considering that Robinhood boasts over 13 million traders, most of whom are not sophisticated investors (institutions like Melvin Capital aren’t trading on their smartphones), that 13% is actually representative of nearly one million retailer traders who are now trading options – many for the first time in their lives. In other words, GameStop has introduced a new generation of retail traders to options products. There’s no indication these traders will go quietly into the dark.
2. Robinhood in the Hot Seat
Robinhood CEO Vlad Tenev was in the hot seat for much of the hearing, as House Democrats and Republicans alike excoriated his company. Lawmakers’ ire was not only trained on Robinhood’s decision to halt buy orders of GameStop and other stocks, but other controversies the company’s been involved in.
Tenev acknowledged his company’s wrongdoing, apologized for Robinhood’s role in the GameStop crisis, and admitted that Robinhood did not have sufficient cash to post collateral with the DTCC. "I’m not going to say that Robinhood did everything perfect and that we haven’t made mistakes in the past,” he told lawmakers. “But what I commit to is making sure that we improve from this, we learn from it, and we don’t make the same mistakes in the future.”
It’s a sensitive time for Robinhood to be under the scrutiny of U.S. federal lawmakers and regulators since they are on the verge of going public. Robinhood, which was valued at over $11 billion in its last funding round, is rumored to be looking at an IPO in 2021.
3. Scrutiny of Payment for Order Flow is High
The way Robinhood makes money – payment for order flow (PFOF), whereby market makers like Citadel Securities pay Robinhood to route users’ trades to their desks – was a recurring theme of debate. And several lawmakers expressed concern that PFOF and big market makers like Citadel pose a threat to the financial system.
“Citadel is one of the winners,” bemoaned Jim Himes, a Democratic congressman who also happens to be a former Goldman Sachs vice president. “They're the casino in this story, and the casino tends to win over time. Robinhood makes a lot of money from the casino.”
Ken Griffin, the hedge fund billionaire who is also majority owner of Citadel Securities, was subject to especially intense questioning by Democratic Representative Brad Sherman, after he dodged the lawmaker’s question about whether market-makers charge all brokers equally.
Scrutiny of PFOF is sure to outlast today’s hearing, since the entire brokerage industry has followed Robinhood’s lead and slashed trading commissions to zero. This industrywide shift has fomented a new generation of day traders, which in turn has driven more PFOF revenue for brokers, but also increased their reliance on PFOF revenue. Earnings from PFOF nearly tripled at the four major brokerages – TD Ameritrade, Robinhood, E*Trade (MS), Charles Schwab (SCHW) — to $2.5 billion in 2020 from $892 million in 2019, according to Yahoo! Finance.
With Senator Elizabeth Warren also pressing Ken Griffin for answers, and with market cop Gary Gensler soon to be appointed SEC chief, the brokers and market makers who benefit from PFOF have ample cause to be worried.
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